**Introduction**

Price spread strategy involves simultaneously buying and selling similar kind of options on the same underlying asset having same maturity/expiry date but with different strike price. That means, this strategy involves two option contracts with two different strike price creating a range having lower strike price and an upper strike price. This strategy is generally for those investors who have moderate price belief as it reduces the loss at the cost of limited gain.

Bearish CALL Price Spread involves selling/writing a CALL option at lower strike price and simultaneously buying a CALL option at a higher strike price on the same underlying asset having same maturity/expiry date.

**Let us understand what is bearish CALL spread strategy using an example-**

Consider an investor who is bearish on stock and expects the share price to remain below $500. His investment horizon is 1-year. Following information is available â€“

Share price is currently trading at $480

Call option at strike price of $500 is currently trading at a premium of $60.85

Call option at strike price of $600 is currently trading at a premium of $29.49

**Case â€“ 01: Selling a **__CALL Option__

Investor is bearish on stock and expects the share price to remain below $500 on expiry. He can simply sell/write a CALL option at a strike price of $500 and will receive premium of $60.85.

Initial premium inflow = $60.85.

Break-even point = Strike price + Initial premium received = $500 + $60.85 = $560.85

**Situation â€“ 01: If the share price on expiry happens to be $450**

CALL option lapses.

Payoff on expiry would be $0

Profit on expiry would be initial premium received = $60.85

**Situation â€“ 02: If the share price on expiry happens to be $560**

CALL option gets exercised against the investor.

Payoff on expiry would be strike price minus share price = $500 - $560 = -$60

Profit on expiry would be initial premium received minus payoff = $60.85 - $60 = $0.85

**Situation â€“ 03: If the share price on expiry happens to be $620**

CALL option gets exercised against the investor.

Payoff on expiry would be strike price minus share price = $500 - $620 = -$120

Loss on expiry would be initial premium received minus payoff = $60.85 - $120 = $59.15

**Situation â€“ 04: If the share price on expiry happens to be $700**

CALL option gets exercised against the investor.

Payoff on expiry would be strike price minus share price = $500 - $700 = -$200

Loss on expiry would be initial premium received minus payoff = $60.85 - $200 = $139.15

Therefore, under CALL option

Maximum Loss = Share Price â€“ Initial premium received [ maximum loss is unlimited ]

Maximum Profit = Initial premium received = $60.85 [ maximum profit is limited ].

Break-even point = Strike price + Initial premium received = $500 + $60.85 = $560.85

**Case â€“ 02: Simultaneously buying and selling CALL Options**

Investor is bearish on stock and expects the share price to remain below $500. Although at the same time he is afraid that his expectations might go wrong which could lead to huge losses in case if the share price happens to be $700, $800 . . . or even $900 on expiry. Therefore, to limit the losses (which could potentially have been unlimited), he can cover his exposure by buying a CALL option at some higher strike price.

This can be done by selling/writing a CALL option at a strike price of $500 receiving a premium of $60.85 and simultaneously buying a CALL option at a strike price of $600 for which he has to pay CALL premium of $29.49.

Now, if the share price rises above $600 then investor will exercise $600 CALL option in favour and receive the payoff accordingly to offset the losses on $500 CALL option thereby creating a hedge position above $600 levels.

Net initial premium inflow = Premium received on $500 CALL â€“ Premium paid on $600 CALL = $60.85 - $29.49 = $31.36.

Break-even point = Lower strike price + Net initial premium received = $500 + $31.36 = $531.36.

**Situation â€“ 01: If the share price on expiry happens to be $450**

Both, $500 CALL & $600 option lapses.

Payoff on expiry would be $0

Profit on expiry would be net initial premium received = $31.36

**Situation â€“ 02: If the share price on expiry happens to be $560**

$500 CALL option gets exercised against the investor while $600 CALL option lapses.

Payoff on expiry on $500 CALL option would be strike price minus share price = $500 - $560 = -$60

Loss on expiry would be net initial premium received minus payoff = $31.36 - $60= $28.64

**Situation â€“ 03: If the share price on expiry happens to be $620**

$500 CALL option gets exercised against the investor while $600 CALL option gets exercised in favour.

Payoff on expiry on $500 CALL option would be strike price minus share price = $500 - $620 = -$120 (exercised against).

Payoff on expiry on $600 CALL option would be share price minus strike price = $620 - $600 = $20 (exercised in favour)

Therefore, net payoff from the strategy = $20 - $120 = -$100

Loss on expiry would be net initial premium received minus payoff = $31.36 -$100= $68.64

**Situation â€“ 04: If the share price on expiry happens to be $700**

$500 CALL option gets exercised against the investor while $600 CALL option gets exercised in favour.

Payoff on expiry on $500 CALL option would be strike price minus share price = $500 - $700 = -$200 (exercised against).

Payoff on expiry on $600 CALL option would be share price minus strike price = $700 - $600 = $100 (exercised in favour)

Therefore, net payoff from the strategy = $100 - $200 = -$100

Loss on expiry would be net initial premium received minus payoff = $31.36 -$100= $68.64

Therefore, under Price Spread Strategy

Maximum Loss = Difference of strike price â€“ Net initial premium received = ($600 - $500) - $31.36 = $68.64 [ maximum loss is limited ]

Maximum Profit = Net initial premium received = $31.36 [ maximum profit is limited ].

Break-even point = Lower strike price + Net initial premium received = $500 + $31.36 = $531.36.

**Benefits of Price Spread Strategy**

Under situation â€“ 04 of both the cases, the loss from the Price Spread Strategy is lower and limited to $68.64 as compared to selling a CALL option in case â€“ 01 were losses are higher and can lead to huge [ limited losses on expiry because of offsetting position in $600 CALL option ].

**Drawbacks of Price Spread Strategy**

Under situation â€“ 01 of both the cases, the loss of initial premium received is lower in Price Spread Strategy as compared to selling a CALL option in case â€“ 01 [ lower initial premium resulting in lower profit ].

Under situation â€“ 02 of both the cases, there is loss from the Price Spread Strategy as compared to profit in selling a CALL option in case â€“ 01 [ lower profit on expiry because of lower initial premium ].

Break-even point in Price Spread Strategy is less as compared to selling a CALL option in case â€“ 01 [ faster break-even because of lower initial premium ].

**Recommendation to the investor**

Bearish CALL Price Spread Strategy should be employed if the investor wants to limit the losses, at the cost of lower gains, incase share price rises steeply (say share price on expiry rises to $700, $800 . . . and so on). This strategy helps investor to limit the losses by offsetting the risk of selling the lower strike price option with the higher strike price option. Ultimately resulting in limited profit of $31.36 and limited loss of $68.64, while in case â€“ 01 i.e., selling only a CALL option can result in unlimited loss.

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